One of the most frequently asked questions I get from Investors who are in the process of understanding my business and how I make money buying debt is “What is a collateralized debt obligation? This question is also very similar to “what happens if the homeowner stops paying their monthly mortgage payment?”
In an earlier post, I talked about the 3 types of real estate distress to highlight which types of distress I invest and which types of distress I choose not to invest. You can read the full blog post here: http://www.sclcapital.com/3-types-of-real-estate-distress/.
Taking a step back, it is important for all of us to understand the fundamentals of debt obligations and why wealthy investors who are highly interested in preserving capital as well as attractive rates of return choose debt as an investment vehicle. Summarizing Wikipedia, a collateralized debt obligation is a promise to pay investors in a prescribed sequence, based on the cash flow the asset collects from the pool of mortgages or other assets it owns. Said another way, homeowners (borrowers) are making an agreement to pay the owners of the mortgage (investors) a stated amount at certain time intervals for a specific duration of time. This is not unique to debt that is collateralized, this is basic business law and what makes a contract valid.
You can read more on Wikipedia here: http://en.wikipedia.org/wiki/Collateralized_debt_obligation
On a deeper level, the structure of a Collateralized Debt Obligation for Wall Street purposes and institutional investing can determine the sequence of payment to investors when pools of loans are bundled into securities. These various pools of investments are called “tranches.” Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is “sliced” into “tranches”, which “catch” the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most “junior” tranches suffer losses first. This is a little advanced for a high level overview.
What is different about a debt obligation being collateralized, also commonly called ‘secured debt’, is in the event of the borrower failing to meet the agreed upon terms of the repayment schedule, the investor or lender can re-posses the underlying asset that is pledged as collateral on the debt obligation.
If we think about the importance of collateral, it can be related to as an insurance policy for investors or lenders. Do you think that your local bank or credit union would loan you money for a mortgage to buy your house if there was no legal action the bank could take to collect the money owed if the borrower woke up one day and simply decided that they no longer felt like making their monthly mortgage payment? The answer is of course not. Banks just like investors in mortgage notes are not interested in gambling. We are interested in having multiple ways to make money independent of the actions taken by the borrower to repay or not repay the collateralized debt obligation.
In the case of mortgage note investing, investors have the legal right to send demand letters as well as ultimately foreclose on the underlying asset, to recapture the principal amount of the investment.
It is possible for people to make loans between each other that are not collateralized or unsecured. This is not my business and don’t have any experience making a loan where Uncle Vinny will threaten to “break knee caps” to collect on money owed. Since half of my family is Italian, I feel entitled to make Godfather reference, but I meant no disrespect. There are usury laws in each state that people must be aware of and these type of unsecured loans can often be called ‘loan sharking’ as they are associated with predatory lending practices sometimes connected with criminal activity.
The key takeaway when starting to understand debt as an investment vehicle is asking about inquiring about if the debt is collateralized or unsecured? If the debt is collateralized such as a mortgage note, what is the liquidation value of the underlying assets and what measures are being taken to protect the capital investment? Think about what banks do to protect their money and see how you can act more like the bank to grow your wealth while protecting your wealth at the same time.
Thank You,
Jeffrey Greco